Hedge Fund Strategies That Could Benefit From Higher Interest Rates

With inflation on the rise, the US Federal Reserve has increased its target range for the federal funds rate and projected further increases in 2022. While higher interest rates often lead to declining asset values, certain hedge fund strategies can actually benefit from this environment.

Here are three hedge fund strategies that could see positive effects from rising interest rates:

1. Commodity Trading Advisors (CTAs)

CTAs take long and short positions in commodities, currencies, equity indexes, and interest rates through the futures market. The inherent leverage in these instruments allows CTAs to potentially increase their returns as interest rates rise. Demand for CTAs has increased due to their neutral or negative correlation with both equity and fixed-income markets.

CTAs can be categorized as medium-term or short-term trend strategies, with the majority of capital invested in the former. These strategies typically exhibit negative correlation with long-only benchmarks and positive skew, which provides tail-risk protection during market downturns.

2. Reinsurance

Reinsurance strategies involve assuming insurance company liabilities for property damage caused by natural disasters. The performance of reinsurance funds has little correlation with the capital markets, and their returns can be enhanced by increases in short-term interest rates.

Reinsurance funds are required to hold reserves for their potential liabilities, usually in short-term securities. As short-term interest rates increase, the returns on these securities also rise, leading to enhanced performance for reinsurance funds.

3. Higher Turnover Relative Value Fixed Income

These strategies involve providing liquidity to complex or less liquid fixed-income securities. Rising interest rates increase volatility in fixed-income markets, which can lead to higher returns for trading-oriented strategies. Managers in this space generate returns through alpha and actively hedge interest rate and credit spread risks.

These strategies have low correlation with the capital markets and can provide some tail-risk protection during market selloffs.

Overall, CTAs, reinsurance, and higher turnover relative value fixed income are examples of hedge fund strategies that could benefit from rising interest rates. As short-term rates rise, these strategies are expected to grow in market share.

In addition, large institutional investors may negotiate performance fees in light of rising interest rates. If short-term rates continue to rise, more institutional investors may request a performance hurdle for the carried interest portion of performance generated by the cash position of the portfolio.

In conclusion, while rising interest rates can have negative effects on the market, certain hedge fund strategies have the potential to thrive in such an environment.